Functional Form in the Demand for Money

Abstract

A general functional form is considered for which the linear and logarithmic functional forms are special cases. The general functional form is a power transformation of each of the variables—each variable is raised to a λ power. This functional form is estimated for the demand for money using the maximum likelihood method. Real money demand is specified to be a function of real current income and a short-term interest rate. The empirical evidence suggests that the logarithmic functional form is appropriate for money stock defined as currency plus demand deposits. For money stock defined to also include time deposits, neither the linear nor logarithmic form seems appropriate. The estimates of λ are insensitive to expansion of the model explaining money demand, but functional form is important for discrimination among alternative hypotheses.